As we approach the final stretch of 2021, one thing is clear: we’ve come a long way from where we sat this time last year. Yields have risen and unemployment has fallen, but inflation and COVID-19 seem to be stickier than once thought.
Coming into 2021, the yield on the five-year Treasury Note was sitting around 35 basis points, about 80 basis points lower than it sits today. We should note, the moves in the Treasury market thus far are speculative, with market participants expecting a rate hike to the third quarter of 2022 and perhaps another coming at the end of 2022, reflecting the risk of persistent inflation and wage pressures. Lingering supply chain bottlenecks and the fastest increase in labor compensation in almost two decades point to upside risks to inflation in 2022.
The consensus within the Fed now appears that waiting until June to hike rates is too long. Federal Reserve Bank of St. Louis President James Bullard was the first to suggest the Fed should speed up its reduction of monetary stimulus by March in response to the surge of inflation. Federal Reserve Chair Jerome Powell is also ready to shift the Fed into an inflation-fighting approach.
During his November 30 testimony to the Senate Banking Committee, Powell said, “At this point the economy is very strong and inflationary pressures are high and it is therefore appropriate in my view to consider wrapping up the taper of our asset purchases perhaps a few months sooner, and I expect that we will discuss that at our upcoming meeting in a couple weeks.”
We don’t disagree with his statements on reducing monthly bond purchases as they are having little to no impact at this point, given the $1.5 trillion of reserves are recycled back into the Fed via the reverse-repurchase facility. But given the continued uncertainty about the Omicron COVID variant, the Fed seems to want the options that a faster taper gives. Powell noted that rate liftoff has a high threshold and, though the market may price for earlier hikes than it had prior to the testimony, we don’t think the Fed will move rates until June. Should the market price for earlier rate hikes, the yield curve may flatten, led by the front end. Any hikes before the third quarter of 2022 could get the market to believe the Fed will hike more than is currently priced, though maybe a bit slower, making the five- and seven-year sectors more susceptible to selloffs than the long end.
U.S. Treasury Yield Curve: 01/01/2021 vs. 12/02/2021
Entering 2021, the U.S. unemployment rate was sitting at 6.3%, and we watched as it marched down to where we sit today at 4.2%. If current trends continue, we believe the unemployment rate should decline by mid-2022 to a level low enough to be considered maximum employment, which would allow the Fed to begin raising rates without damaging its credibility.
The most likely factor that may hold back the rate liftoff is a slow labor-market recovery. As the FOMC has stated several times, one of the criteria for a hike is for labor-market conditions to reach levels consistent with its assessment of maximum employment. However, they have not given a numerical threshold, and by remaining vague, the FOMC keeps the option to hike earlier if inflation runs hotter than it expects. While the FOMC considers a range of labor-market indicators, the only one it published in the quarterly Summary of Economic Projections is the unemployment rate. The latest saw the median participant projecting a 4% long-run neutral unemployment rate. It would only take about 200,000 new jobs per month for the unemployment rate to fall to that level in June 2022 if the labor force participation rate remains at its current level.
If the FOMC thinks the participation rate needs to return to its pre-pandemic level to hike rates, then more jobs would be needed. However, a slow labor market recovery isn’t a deal breaker for a faster rate liftoff. Bloomberg Market Intelligence predicts that the households with incomes around the levels in sectors experiencing more severe labor shortages have about four to six months of financial cushion from excess savings. For these reasons, we think that it is likely that we see the Fed begin to raise rates in mid-2022.
As we wrapped up November 2021, we were reminded of how COVID-19 still holds a strong grip on the markets, as news of the new Omicron variant led to the worst Black Friday trading session on record. Investors initially dialed back bets on the pace of monetary policy tightening, pushing back the timing of a first 25 basis point rate increase to September from June in the interest rate futures market. There was an 18-basis-point yield drop in the five-year U.S. Treasury, which has long been a barometer of future Fed shifts, and the 10-year fell below 1.50%. The unknowns of this latest COVID-19 variant have caused a spike in volatility in the markets, with fed funds futures currently pricing in the first hike up to July.
We expect further volatility in 2022. Much remains unknown about the strength of the economy, prevalence of COVID-19 variants and the FOMC’s managing of their unprecedented balance sheet. We recommend sticking to your plan, whether you’re building a ladder or managing a barbell. Dollar cost averaging has proven to be more efficient than trying to time the market.
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